To the Shareholders and Directors of Fairholme Funds, Inc.:
What a horrible year for performance! Market prices plunged in many of our Funds’ core holdings in spite of strengthening book values with huge reserving for legacy issues.

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In more-normal times, we expect portfolio companies to generate 10% returns on book values, which would lead to much higher common stock returns with discounts to those book values. However, current events always reverberate much louder than the financial histories of past cycles; positive results and actions are now needed to swing market sentiment and prices toward more balanced views and values. AIG’s $1B common stock buy-back, Buffett’s transaction with Bank of America, CIT’s rapid debt refinancing, and MBIA CEO Jay Brown’s repeated stock purchases all point to improving fundamentals – the process has started.

AIG common stock and warrants are by far the largest issuer holding of The Fairholme Fund and the company is worthy of a Dickens novel. Started in Shanghai by U.S. citizen C.V. Starr in 1919, built into a shining example of how America can compete and win around the world by an imperial M.R. Greenberg, torn apart by a ruthless AG Spitzer, and now rising from the ashes of a great tragedy. The company’s book value of $45 per share is heading to $55 in the near future and yearly earnings power of $4 per share will further propel shareholder value. Yet, AIG’s market price plummeted to less than half of book value due to what we can only surmise as a belief that the United States Treasury will sell its 77% ownership stake below the Department’s $29 cost. Why this is negative for long-term investors we do not know.
Sears remains a large position in all of our funds, notwithstanding announcements in late December of falling sales and margins, rising expenses, and write-downs. Investors fled with this New Year’s greeting before Chairman Lampert purchased over $150 million of common for his personal account. For many reasons, including management, we continue to believe the assets of this iconic brand to be a multiple of values implied by its current stock market price and continue to see the beginning of a new Berkshire Hathaway.

Bank of America was our worst laggard – even with results showing $20 per share of book value, $5 per share of reserves for bad debt and legal issues, and yearly pre-provision, pre-tax cash flows growing to $4 per share. Shareholders can find our analysis at fairholmefunds.com. If only BofA could buy back its stock at current prices that are near one-third of book value....

Besides cash levels, other main differences among The Fairholme Funds are in the holdings of small-quantity ideas in The Allocation Fund due to capitalization and income-generating ideas in The Income Fund due to mandates.

The Allocation Fund currently owns near its legal limit of an outstanding issue of BofA warrants rather than its common stock. Each warrant gives the right, but not the obligation, to purchase one share of common at $13.30 until January 16, 2019. The strike is quite high relative to current prices, but it lowers in price and the ratio of shares to warrants increases when dividends are paid, and with certain other events. The Allocation Fund also owns warrants on AIG, J.P. Morgan Chase, and Wells Fargo with similar “double-ratchet” features.
MBIA common stock is The Allocation Fund’s largest position. Recent legal settlements paid and reserves taken by defendants are convincing skeptics of the company’s ability to more than just survive. Following GAAP, the company reports a book value of about $12 per share. Following Statutory Accounting Principles (SAP) utilized by insurance regulators, book adjusts to $16. Assuming an orderly run-off, the company calculates an adjusted book value of $35. Each method has its strengths and weaknesses and does not include a value for new business.

High-yielding MBIA bonds are the largest issuer-based position while Emigrant
Savings Bancorp and Regions Financial remain large positions in The Income Fund. The Fund’s current yield is 9.5%, yield to maturity is 11.7%, and average duration is 4 years.*Not too shabby. In 2011, The Fairholme Fund lost 32.42% versus a gain of 2.11% for the S&P 500 Index (“S&P 500”).

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In great years, we asked shareholders not to be swayed by short-term performance. The same is true in a bad year. One circling of the Sun is too short a time to differentiate between good and lucky. Thus, we remain optimistic given our performance since inception and a belief that while history does not exactly repeat, it does rhyme. Unemployment is coming down and elections are near. Our favorite economist,Warren Buffett, is bullish on America. Year-end reports show continuing, positive trends. Our companies are strong and cheap. Shareholders have kept their courage and conviction under stress. Fairholme has kept its word to focus on value-based, long-term investments. We will stay the course.
Thank you for your continued trust,
Bruce R. Berkowitz
Managing Member, Fairholme Capital Management LLC

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